KOSS

Koss Corp. 10-Q Summary: Quarter Ended March 31, 2011

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended March 31, 2011, and the nine-month period ended on the same date. Koss Corporation is a smaller reporting company incorporated in Delaware, specializing in consumer audio products. The filing highlights the company's ongoing recovery from significant unauthorized transactions discovered in December 2009, which involved approximately $31.5 million in fraudulent activity from fiscal 2005 through 2009.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: Net sales decreased 2.7% ($234,967) for the quarter and 3.8% ($1.23 million) for the nine months compared to the prior year. The decline is attributed to the absence of a large initial stocking order by a U.S. retailer in the prior year and lower sales to European distributors.
• Profitability: The company reported a significant turnaround in operating results. For the nine months ended March 31, 2011, the company posted an operating income of $4.47 million, compared to an operating loss of $4.57 million in the prior year. This improvement is primarily due to the absence of the $10.3 million in unauthorized transaction expenses recorded in the prior year.
• Unauthorized Transaction Costs: In the current quarter, the company recorded a net benefit of $376,544 related to unauthorized transactions (recoveries exceeding legal fees). In the prior year quarter, this line item represented a net cost of $310,547.
• Expenses: Selling, general, and administrative (SG&A) expenses increased due to higher profit-based compensation, legal fees for patent work, and new product development costs.

Outlook, Risks, and Management Commentary

• Liquidity: Management believes cash generated from operations and the $8 million secured credit facility with JPMorgan Chase Bank provide adequate liquidity for operations, debt service, and dividends. The company intends to continue paying regular quarterly dividends.
• Legal Proceedings: The company is involved in multiple litigation matters stemming from the unauthorized transactions, including a class action lawsuit, shareholder derivative suits, and an ongoing SEC investigation. The company has initiated actions against third parties, including American Express and its former auditor, Grant Thornton LLP.
• Recoveries: The company expects to receive additional proceeds from the auction of items seized from the former Vice President of Finance, Sujata Sachdeva. Gross proceeds from recent auctions were approximately $1.1 million, though net proceeds are not yet finalized.
• Internal Controls: Management concluded that disclosure controls and procedures were not effective as of March 31, 2011, due to the inability to complete the testing and confirmation process of remedial measures implemented following the fraud. A new business system implementation is expected to be completed by September 30, 2011.

Key Facts for Investor Verification

• Verify the status and expected net proceeds from the U.S. Marshals Service auctions of seized assets related to the unauthorized transactions.
• Monitor the resolution of pending litigation, specifically the class action suit and the lawsuit against former auditor Grant Thornton LLP.
• Confirm the timeline for the implementation of the new business system and the subsequent testing required to declare internal controls effective.
• Review the company's ability to maintain its dividend payments given the increase in inventory levels and accounts receivable.
• Assess the impact of the $3.6 million outstanding balance on the $8 million credit facility and compliance with financial covenants.